CFA mock exam level iii mock exam 2010a ans

2010 Level III Mock Exam ANSWERS AND REFERENCES Questions through relate to Ethical and Professional Standards Frank Litman Case Scenario Frank Litman, CFA, has recently been hired as a portfolio manager for Twain Investments, a small regional asset management firm For the past ten years, Litman has managed a limited number of accounts belonging to family and friends He started managing these accounts when he was enrolled in graduate school All the accounts are too small to meet Twain’s minimum balance requirement of $5 million, and generate only modest fees for Litman Litman disclosed the arrangement to the Human Resource (HR) manager when he interviewed for the position of portfolio manager The HR manager agreed that the accounts were too small and would probably never be large enough to meet Twain’s minimum requirement Upon accepting the position with Twain, Litman met with each of his non-Twain clients and recommended that they find another financial advisor Each of them asked Litman to continue managing their money as a personal favor, arguing that a different advisor would undoubtedly charge higher fees Following the meetings, Litman sent separate letters to both the Twain HR manager and his non-Twain clients explaining his employment relationship to each The following month, Litman updated the promotional material he shares with all of his clients and prospects The material summarizes Litman’s portfolio trading strategy, which he developed by analyzing twenty years of historical data In his analysis, Litman determined that his strategy, which invests in large-capitalization U.S stocks, would have outperformed the S&P 500 Index over the last 20 years—with an average annual return of 10.91 percent versus 10.42 percent for the S&P 500 The concluding paragraph of the brochure states, ―We believe using this trading strategy over the long term will lead to superior performance compared with the S&P 500.‖ The brochure includes a footnote in small print stating, ―Results are gross before tax so may be higher than what actual results would have been over the given period Past performance cannot guarantee future results ‖ At Twain, Litman has discretionary authority over the portfolios of individual stocks and bonds for about 30 clients His ten largest clients vary widely in age, occupation, and wealth For a variety of reasons, each of these accounts requires significant attention The remaining two-thirds of Litman’s clients are stable, long-term investors, all of whom are saving for retirement Litman performs comprehensive quarterly reviews with the owners of the ten largest accounts and similar annual reviews with the remaining clients Recently, he made an exception to this rule when he learned that one of his smaller, less active clients had unexpectedly inherited $600,000 from an aunt’s estate Litman met By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose with the client and performed a comprehensive review of the client’s financial situation even though only three months had passed since their last meeting With a new CEO, Twain, which adheres to the Asset Manager Code of Professional Conduct, experiences significant change during the year when management hires a compliance officer The compliance officer immediately begins to update the firm’s policies and procedures After a thorough analysis, the firm decides to outsource its back-office operations and hires an independent consultant to review client portfolio information At the same time, they add several research and investment staff and upgrade the information management system They eliminate paper records in favor of electronic copies and develop a business-continuity plan based on current staffing Eighteen months later, the compliance officer resigns Rather than hire an external replacement, management designates one of Twain’s senior portfolio managers as the new compliance officer The compliance officer reviews both firm and employee transactions and reports to the chief executive officer Which of the following is the most correct action for Litman to follow in order to comply with the Standards in regards to Twain and non-Twain clients? A Do nothing B Inform his immediate supervisor C Obtain written consent from both Twain and non-Twain clients Answer: C ‖Guidance for Standards I – VII‖ 2010 Modular Level III, Vol 1, pp 75, 89-91 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity According to Standard IV (B), Litman must obtain written permission from all parties involved By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose According to CFA Institute Standards and Recommended Procedures for Compliance, which of the following information in regards to Litman managing funds for his family and friends is least likely required for him to comply with the Duty to Employer? A The names of his non-Twain clients B The amount and type of compensation received C The duration of the investment management agreements Answer: A ‖Guidance for Standards I – VII‖ 2010 Modular Level III, Vol 1, pp 67, 75 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity According to the Recommended Procedures for Compliance for Standard IV (B), members should disclose the terms of any agreement under which a member will receive additional compensation Terms include the nature of the compensation, the approximate amount of compensation, and the duration of the agreement According to Standard III (E), members must keep information about current and prospective clients confidential In the footnote of his promotional material about the performance of portfolio trading strategy, Litman is most likely not in compliance with the CFA Institute Standards of Professional Conduct with respect to: A tax B fees C results Answer: C ‖Guidance for Standards I – VII‖ 2010 Modular Level III, Vol 1, pp 64- 65 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose The Code (Standard III (D)) does not prohibit the use of simulated performance analysis as long as it is clearly stated the results are simulated While he has managed actual accounts for friends and family for ten years, he as used 20 years of historical data to prepare results Did Litman violate any CFA Institute Standards in regards to his performance reviews? A No B Yes, with respect to the frequency of reviews for his ten largest clients C Yes, with respect to his recent review for the client with the inheritance Answer: A ‖Guidance for Standards I – VII‖ Modular Level III, Vol 1, pp 60-62 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity According to Standard III (C) Suitability, members shall make a reasonable inquiry into a client or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment recommendations or taking investment action and must update this information regularly Such an inquiry should be repeated at least annually and prior to material changes to specific investment recommendations or decisions on behalf of the client Are Twain’s actions and procedures during the first year of the new CEO’s tenure in compliance with the Asset Manager Code of Professional Conduct? A Yes B No, with respect to back-office operations C No, with respect to independent consultant Answer: A Asset Manager Code of Professional Conduct, including Appendix A (CFA Institute, Centre for Financial Market Integrity, 2005) 2010 Modular Level III, Vol 1, pp 222 - 223, 231 Study Session 2-6-b By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Interpret the Asset Manager Code in situations that present issues of compliance, disclosure, or professional conduct The Code allows outsourcing—although managers retain the liability and responsibility for any outsourced work Managers have a responsibility to ensure the information they provide to clients is accurate and complete By receiving an independent third-party confirmation or review of that information, clients can have an additional level of confidence that the information is correct and can enhance the Manager’s credibility Such verification is also good business practice With respect to its most recent compliance officer, are Twain’s actions and procedures in compliance with the recommendations and requirements of the Asset Manager Code of Professional Conduct? A Yes B No, with regard to independence C No, with regard to reporting lines Answer: B Asset Manager Code of Professional Conduct, including Appendix A (CFA Institute, Centre for Financial Market Integrity, 2005) 2010 Modular Level III, Vol 1, pp 230 - 231 Study Session 2-6-b Interpret the Asset Manager Code in specific situations that present issues of compliance, disclosure, or professional conduct According to the Code Recommendations and Guidance (D 2), while the new compliance officer reports directly to the CEO he is not independent in that he is also part of the investment team meaning he would review his own investment actions By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Questions through 12 relate to Ethical and Professional Standards Jorge Peña Case Scenario Jorge Peña is a broker at Northwest Securities and CFA Institute member who passed Levels I and II of the CFA® examination in 2008 and 2009 Because of a demanding work schedule, he did not enroll for the 2010 Level III exam He hopes to enroll for the 2011 Level III exam In January 2010, Peña decides to apply for a broker position with Harvest Financial and updates his résumé (curriculum vitae) He prominently displays ―CFA® candidate‖ on his resume and states that he ―completed both Level I and Level II of the Chartered Financial Analyst Program.‖ During an interview with Peter Williams, a junior partner of Harvest Financial, Peña explains he currently has more than 100 brokerage clients Based on relationships with those clients over the years, he feels confident that at least half of them will transfer their accounts to Harvest if he is employed there Under the ―Personal‖ section of his résumé, Peña lists ―referee for regional football league‖ and ―member of investment committee at the Mueller School.‖ Peña has been refereeing football matches for five years It is a significant time commitment, but he explains that he enjoys the activity and that the fees of $50 per game more than pay for his travel expenses Peña and Williams agree that $50 per game is not material They then discuss Peña’s role on the investment committee of the Mueller School The committee monitors and evaluates the performance of the school’s asset managers and brokers, including Harvest It is a volunteer position, but the school allows all volunteers free use of the school’s athletic facilities The School recently started charging nonstudents and faculty a membership fee of $500 per year to help recover their investment in the new athletic equipment Peña and Williams agree that neither his refereeing nor his investment committee activities will interfere with his duties at Harvest After lunch, Williams introduces Peña to a former colleague, Gabriella Martinez who happens to be a client of Peña’s current employer and who also attended the same university as Peña The colleague asks, ―In what area is your degree?‖ Peña replies, ―I mostly studied finance I found the coursework to be very helpful preparation for the Chartered Financial Analyst program.‖ He then adds, ―You should move your account from Northwest Securities, there are rumors they are in trouble, which is why I want to leave‖ One month later, Peña accepts an offer of employment from Harvest Financial and formally discloses to the Human Resources department his refereeing of football matches By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose and that he sits on the Mueller School investment committee On the first day in his new job, he hangs a framed copy of the CFA Institute Code of Ethics on his wall and places a copy of the Standards of Practice Handbook on his bookshelf for easy reference Later that day, Peña uses public records to contact his clients He informs them of his new position and asks them to transfer their accounts to Harvest so he can continue acting as their broker One month after starting his new job, only 25 of Peña’s clients have transferred their accounts to Harvest At Harvest, Peña attends an educational seminar about a new tax-advantaged investment program available for clients saving for college and university expenses The program offers families the opportunity to obtain growth and distribution of earnings that are free from federal taxes More than 80 individual plans are available and more than onequarter provide additional local tax benefits In the interest of time and for the sake of simplicity, the Harvest supervisor provides information on only one plan, which offers only federal tax benefits During the seminar, the supervisor shows the federal tax savings available under the plan given a number of different scenarios He informs the brokers that the plan is subject to the same compliance and suitability requirements that apply to the sale of non-tax advantaged products The supervisor then distributes the paperwork associated with the plan along with the firm’s compliance and suitability requirements When listing himself as a CFA® candidate on his résumé (curriculum vitae), did Peña violate any CFA Institute Standards of Professional Conduct? A No B Yes, with regard to enrollment C Yes, with regard to completion level Answer: B Guidance for Standards I – VII, CFA Institute 2010 Modular Level III, Vol 1, pp 103-105 Study Sessions 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity Peña violated Standard VII (B) Responsibilities as a CFA Member or CFA Candidate: References to CFA Institute, the CFA Designation, and the CFA Program Peña is not a candidate in the CFA examination program because he is not enrolled to sit for a specific examination By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose With respect to the fees he receives as a football referee, has Peña violated any CFA Institute Standards? A No B Yes, because he failed to receive written consent from his employer C Yes, because he failed to receive written consent from all parties involved Answer: A Guidance for Standards I – VII, CFA Institute 2010 Modular Level III, Vol 1, p 75 Study Sessions 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity Disclosure of additional compensation arrangements (Standard IV (B)) is required in situations where consideration might reasonably be expected to create a conflict of interest with the employer’s interest The fees in question are small and unrelated to Peña’s professional activities They create no conflict of interest with the employer as was verbally confirmed in the interview process According to CFA Institute Standards, after commencing employment with Harvest, Peña is least likely to have violated which Standard with regard to his relationship with Mueller School? A Misrepresentation B Conflicts of Interest C Additional Compensation Answer: A Guidance for Standards I – VII, CFA Institute 2010 Modular Level III, Vol 1, pp 29, 75-76, 89 - 91 Study Sessions 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity It does not appear that Pena has made any misrepresentations However, Peña must disclose benefits he receives in exchange for his services on the investment By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose committee According to Standard IV (B) Duties to Employers: Additional Compensation Arrangements, members must not accept benefits or consideration that competes with, or might reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all parties involved In addition, Pena must also disclose the potential conflicts of interest (Standard VI (A)) that may arise given Horizon potentially trades the same shares as those held within Mueller’s portfolio and acts as their broker 10 During Peña’s conversation with Martinez, which Standard below is least likely to have been violated? A Loyalty B Misrepresentation C Reference to the CFA Program Answer: C Guidance for Standards I – VII, CFA Institute 2010 Modular Level III, Vol 1, pp 29, 69, 103-107 Study Sessions 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity In the conversation with Martinez, Peña did not violate Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program because he did not call himself a candidate but explained his participation in the program and properly stated that he had passed Levels I and II of the CFA Program 11 Based only on the information describing his first month of employment at Harvest, did Peña violate any CFA Institute Standards during that time? A No B Yes, because he solicited clients from his previous employer C Yes, because he failed to inform his supervisor in writing of his obligation to comply with the Code and Standards Answer: A Guidance for Standards I – VII, CFA Institute 2010 Modular Level III, Vol 1, pp 15-17, 29-31, 69-71 Study Sessions 1-2-a By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity According to Standard IV (A) Peña is free to solicit clients using public information Although Peña did not deliver as many clients as he had hoped, he did not make any promises as to the number of clients he would bring with him to his new employer Finally, while encouraged, he is not obligated to inform his supervisor in writing of his obligation to comply with the Code of Ethics 12 Based on the information provided regarding the tax-advantaged savings plan, the Harvest supervisor is least likely to have violated the Standard relating to: A Suitability B Independence and Objectivity C Responsibilities of Supervisors Answer: B Guidance for Standards I – VII, CFA Institute 2010 Modular Level III, Vol 1, pp 21-23, 60-62, 76-78, Study Sessions 1-2-a, b Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards The Standard regarding Independence and Objectivity (Standard I (B)) requires members to use reasonable care to achieve independence and objectivity According to the Standard, members must not offer or accept any gifts or benefits that reasonably could be expected to compromise their independence Based on the information provided, the supervisor has not received any benefits that would compromise his independence Nevertheless, the supervisor failed to exercise thoroughness in analyzing the various tax-advantaged plans and lacked a reasonable basis for suggesting one plan over the many others As a supervisor, he failed to establish adequate compliance procedures for determining the suitability of tax-advantaged programs, instead using standard compliance procedures designed for non-tax-advantaged products By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Client B’s portfolio holds $40 million of US large cap value stocks with a portfolio beta of 1.06 This client wants to shift $22 million from value to growth stocks with a target beta of 1.21 Allison will implement this shift using S&P/Barra Growth and S&P/Barra Value futures contracts Client C anticipates receiving $75 million in December This client is optimistic about the near-term performance of the equity and debt markets and does not want to wait until the money is received to invest it The client wants Allison to establish a position that allocates 60 percent of the money to a well-diversified equity portfolio with a target beta of 1.00 and 40 percent of the money to a long-term debt portfolio with a target modified duration of 5.75 Allison plans to use the December U.S Treasury-bond futures to establish the debt position Client D’s portfolio contains $60 million in U.S large cap growth stocks with a beta of 0.95 and $25 million in US Treasury bonds with a modified duration of 5.20 The client believes both stocks and bonds will have negative returns over the next 3-month period Allison recommends converting the equity and bond exposures to cash by using futures contracts Client E has $10 million in cash and is optimistic about the near-term performance of the large-cap stocks in the U.S equity market The client anticipates positive performance for approximately months at which time inflation fears will begin to be priced into the market and the large-cap stocks will underperform cash Client E asks Allison to implement a strategy that will create profit from this view if it proves to be correct and can be exited quickly if it proves to be incorrect 43 With respect to Client A, Allison’s most appropriate conclusion is the futures transaction used to adjust the beta of the portfolio was: A effective B ineffective because the effective beta on the portfolio was 1.27 C ineffective because the effective beta on the portfolio was 1.64 Answer: B ‖Risk Management Applications of Forward and Futures Strategies,‖ Don M Chance 2010 Modular Level III, Vol 5, pp 352-354 Study Session 15-41-a Demonstrate the use of equity futures contracts to achieve a target beta for a stock portfolio, and calculate and interpret the number of futures contracts required By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose The effective beta is the (hedged) return on the portfolio divided by the return on the market The return on the market is -3.5% The return on the portfolio is 5.1% plus the return on the futures position The return on the (short) futures position relative to the unhedged portfolio is -25 x (119,347 – 124,450) / 20,000,000 = +0.0064 Effective beta = (-0.051 + 0.0064) / -0.035 = 1.27 44 When implementing the shift from value to growth stocks for Client B, the number of S&P/Barra value future contracts Allison shorts is closest to: A 177 B 182 C 187 Answer: C ‖Risk Management Applications of Forward and Futures Strategies,‖ Don M Chance 2010 Modular Level III, Vol 5, pp 368-371 Study Session 15-41-e Demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure to an asset class in advance of actually committing funds to the asset class To convert $22 million of the value-stock portfolio to cash (beta=0) will require: NV f T S f S = ((0 – 1.06)/1.03) x (22,000,000/120,875) = -187.3 value f futures 45 The number of December U.S Treasury-bond futures contracts Allison buys for Client C is closest to: A 229 B 235 C 335 Answer: B ‖Risk Management Applications of Forward and Futures Strategies,‖ Don M Chance 2010 Modular Level III, Vol 5, pp 371-374 Study Session 15-41-e By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure to an asset class in advance of actually committing funds to the asset class The number of bond futures required is: MDUR T MDUR B MDUR f N bf B = (5.75 – 0)/ (6.87) x (30,000,000/106,906) = fb 234.9 46 The number of S&P/Barra Growth futures contracts needed to convert Client D’s stock portfolio into cash is closest to: A 422 B 511 C 618 Answer: A ‖Risk Management Applications of Forward and Futures Strategies,‖ Don M Chance 2010 Modular Level III, Vol 5, pp 360-362 Study Session 15-41-c Create synthetic cash by selling stock index futures against a long stock position A is correct because to convert $60 million of the growth stock portfolio to cash (beta=0) will require: NV f T S f S = ((0 – 95)/1.15) x (60,000,000/117,475) = -422 growth f futures 47 The number of U.S Treasury futures contracts required to convert Client D’s bond exposure to cash is closest to: A 177 B 234 C 309 Answer: A By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose ‖Risk Management Applications of Forward and Futures Strategies,‖ Don M Chance 2010 Modular Level III, Vol 5, pp 364-369 Study Session 15-41-d Demonstrate the use of equity and debt futures to adjust the allocation of a portfolio between equity and debt A is correct because the number of bond futures required is: N bf MDUR T MDUR B MDUR f B = (0 - 5.20)/ (6.87) x (25,000,000/106,906) = fb 177.0 futures 48 To implement Client E’s request, Allison’s most appropriate course of action is to purchase: A risk-free bonds and buy S&P 500 index futures contracts B the stocks in the S&P 500 index and sell S&P 500 index futures contracts C the stocks in the S&P 500 index and sell U.S Treasury bond futures contracts Answer: A ―Risk Management Applications of Forward and Futures Strategies,‖ Don M Chance 2010 Modular Level III, Vol 5, pp 358-360 Study Session 15-41-b Construct a synthetic stock index fund using cash and stock index futures (equitizing cash) These steps create a synthetic stock index fund that replicates a position in the underlying stocks This is an appropriate strategy since Client E is long $10 million in cash The synthetic stock index fund results in significant transaction cost savings and preserves the liquidity Client E requires By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Questions 49 through 54 relate to Portfolio Management of Global Bonds Bae Chung Case Scenario Bae Chung, CFA, is the owner of Kyung Securities, a small boutique firm that manages US$4.2 billion in leveraged fixed income portfolios for clients Chung has been meeting with managers of a pension fund that is interested in placing $500 million under Kyung’s management and is preparing a proposal for them At a meeting with the pension fund’s representatives, Chung was asked to explain Kyung’s use of leverage Chung replied, ―We use the repo market to borrow against client assets and leverage up portfolio returns Our mandate allows us to borrow between and 75 percent of the equity of the portfolio, depending on our market outlook Chung then makes the following statements: Statement 1: In the current market, our average client portfolio has an expected asset return of 7.40 percent, our average portfolio leverage is 40 percent, and we pay 4.25 percent in the repo market Statement 2: We place client assets that are used in these repurchase agreements in a custodial account at our bank, rather than using wire transfer of title This delivery method results in lower delivery charges and lower repo rates.‖ The proposal that Chung is creating discusses Kyung’s fixed income investment philosophy: ―We seek the highest risk-adjusted returns by purchasing bonds and other fixed income securities that our models indicate are underpriced with respect to credit risk characteristics Our investment policy requires that we purchase only investment grade (BBB-rated or higher) securities and sell any security that is downgraded to speculative grade Further, our policy requires that we use derivatives to hedge credit risk for any position rated below A We not consider a client’s target duration until after the portfolio is formed, at which time we use interest rate futures contracts to modify the duration of the portfolio, as necessary.‖ Chung develops an example of changing a portfolio’s duration based on the data in Exhibit By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Exhibit Bond Portfolio and Bond Futures Data Portfolio value $10,000,000 Portfolio duration 6.5 years Target duration 9.0 years Price of cheapest to deliver bond $98,000 Duration of cheapest to deliver bond 8.62 Conversion factor for cheapest to deliver bond 1.15 Based on earlier discussions with the pension fund’s managers, Chung was prepared to recommend a model portfolio with a duration of 5.0 years, measured against U.S interest rates More recently, Chung was told that the pension fund owns $100 million worth of Australian bonds that must be held in the $500 million portfolio for the next 12 months These bonds have a duration of 3.2 years and Chung estimates that Australia’s country beta is 0.80 The expected (local currency) return on the bonds is 8.50 percent, and the 1year risk-free yields are 1.3 percent in the U.S and 4.6 percent in Australia The spot exchange rate is USD0.69/AUD and the one-year forward rate is USD0.67/AUD 49 Based on Statement 1, the expected return of Kyung’s average client portfolio is closest to: A 8.66% B 10.55% C 11.81% Answer: A ―Fixed-Income Portfolio Management – Part II,‖ H Gifford Fong and Larry D Guin, CFA 2010 Modular Level III, Vol 4, pp 107-109 Study Session 10-30-a Evaluate the effects of leverage on portfolio returns and duration RP = rF + (B/E) × (rF – k), where RP = portfolio rate of return, where rF = return on funds invested, B = amount of borrowed funds, E = amount of equity, and k = cost of borrowing Assuming $100 invested, then, 40 Rp 7.40% (7.40% 4.25%) 8.66% 100 By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose 50 Chung’s Statement regarding delivery of assets in repurchase agreements is most likely: A correct B incorrect with respect to repo rates C incorrect with respect to delivery charges Answer: B ―Fixed-Income Portfolio Management – Part II,‖ H Gifford Fong and Larry D Guin, CFA 2010 Modular Level III, Vol 4, pp 110-111 Study Session 10-30-b Discuss the use of repurchase agreements (repos) to finance bond purchases and the factors that affect the repo rate Repo rates will reflect the delivery requirement, with (all else the same) the lowest rates provided for physical delivery, the next lowest for wire transfer of title, the next for delivery to a custodial account, and the highest for no delivery Delivery charges are the reverse of this, with the highest for physical delivery, lower for wire transfer, lower still for delivery to a custodial account, and none for no delivery 51 Chung’s proposal mentions the use of derivatives to hedge credit risk Given Kyung’s policy, which of the following instruments would most likely be used? A Binary credit options B Credit spread options C Credit spread forwards Answer: A ―Fixed-Income Portfolio Management – Part II,‖ H Gifford Fong and Larry D Guin, CFA 2010 Modular Level III, Vol 4, pp 123-127 Study Session 10-30-g Compare and contrast default risk, credit spread risk, and downgrade risk, and demonstrate the use of credit derivative instruments to address each risk in the context of a fixed-income portfolio According to the vignette, Kyung’s policy requires that bonds whose ratings fall from BBB to BB be sold and that bonds with BBB ratings be hedged This means By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose that the portfolio must be protected from downgrade risk, requiring the use of a binary credit put option that pays the holder if the bond’s rating falls below investment grade 52 According to the data in Exhibit 1, the number of futures contracts that must be purchased to meet the portfolio’s target duration is closest to: A 26 B 30 C 34 Answer: C ―Fixed-Income Portfolio Management – Part II,‖ H Gifford Fong and Larry D Guin, CFA 2010 Modular Level III, Vol 4, pp 116-118 Study Session 10-30-d, e Demonstrate the advantages of using futures instead of cash market instruments to alter portfolio risk Construct and evaluate an immunization strategy based on interest rate futures The approximate number of contracts needed to meet a specific target duration is defined as: (DT - DI) PI Conversion factor for the CTD bond DCTD PCTD where DT is the target duration, DI is the initial portfolio duration, PI is the initial value of the portfolio, DCTD is the duration of the cheapest to deliver bond, and PCTD is the price of the cheapest to deliver bond Then, (9.0 - 6.5) 10,000,000 1.15 =34 8.62 98,000 53 The contribution to the portfolio’s duration from the Australian bond is closest to: A 0.51 years B 1.44 years C 2.56 years Answer: A ―Fixed-Income Portfolio Management – Part II,‖ H Gifford Fong and Larry D Guin, CFA By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose 2010 Modular Level III, Vol 4, pp 131-132 (see example 16) Study Session 10-30-i Evaluate 1) the change in value for a foreign bond when domestic interest rates change and 2) the bond’s contribution to duration in a domestic portfolio given the duration of the foreign bond and the country beta A portfolio’s duration is the weighted average of the duration of the bonds in the portfolio First calculate the adjusted duration which equals the foreign bond’s duration multiplied by the country beta, or 3.2 × 0.8 = 2.56 Then multiply this result by the bond’s weight in the portfolio: 100 2.56 20 2.56 0.51 500 54 Given the exchange rate and interest rate data provided, if the Australian currency risk is fully hedged, the bond’s expected return will be closest to: A 3.90% B 5.20% C 5.60% Answer: C ―Fixed-Income Portfolio Management – Part II,‖ H Gifford Fong and Larry D Guin, CFA 2010 Modular Level III, Vol 4, pp 133-137 Study Session 10-30-j Recommend and justify whether to hedge or not hedge currency risk in an international bond investment The hedged return is defined as the local return of the bond plus the forward discount or premium, or: F - S 0.67 0.69 f 2.90% S 0.69 , where F is the forward rate and S is the spot rate The hedged return is the local return plus the forward premium/discount (the cost of the forward hedge) or 8.50% + -2.90% = 5.60% By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Questions 55 through 60 relate to GIPS Arcadia Case Scenario Arcadia LLP is one of several independently operated investment management subsidiaries of Swiss Corp, a global bank Arcadia is headquartered in Philadelphia and specializes in the management of equity, fixed income and real estate portfolios Arcadia’s Chief Executive Officer recently hired Joan Westley, CFA as Chief Compliance Officer to achieve compliance with the Global Investment Performance Standards (GIPS) Arcadia just opened a division in Phoenix, incorporated as Arcadia West, LLP to accommodate one of its portfolio managers and his staff who manage a hedge fund The staff in Phoenix works exclusively on the hedge fund’s strategy using an investment process distinct from the one used in the Philadelphia office Westley makes the following statement at a meeting with the CEO, ―I am establishing and implementing policies and procedures to ensure Arcadia is in compliance with GIPS Although the hedge fund won’t be in compliance, it won’t impact our ability to be firmwide compliant, because it is in an autonomous unit We will be the first Swiss Corp subsidiary to be compliant Keep in mind that even after implementation, we will not be able to claim compliance until our performance measurement policies, processes, and procedures are verified by an independent firm.‖ Westley begins her review of Arcadia’s current policies She first reviews three policies regarding input data: Policy 1: Policy 2: Policy 3: The accounting systems record the cost and book values of all assets Portfolio valuations are based on market values, provided by a third party pricing service Transactions are reflected in the portfolio when the exchange of cash, securities, and paperwork involved in a transaction is completed Accrual accounting is used for fixed income securities and all other assets that accrue interest income; dividend-paying equities accrue dividends on the ex-dividend date Next, Westley reviews Arcadia’s policies for return calculation methodologies: Policy 4: Arcadia uses the Modified Dietz method to compute portfolio timeweighted rates of return on a monthly basis Returns for longer measurement periods are computed by geometrically linking the monthly returns By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose Policy 5: Policy 6: Arcadia revalues portfolios when capital equal to 10 percent or more of current market value is contributed or withdrawn Returns are calculated after deduction of trading expenses Cash and cash equivalents are excluded in total return calculations Custody fees are not considered direct transaction costs Westley also looks at the investment policy statements (IPS) for the three sample portfolios that are included in Arcadia’s large capitalization equity composite: Portfolio A: Portfolio B: Portfolio C: A portfolio managed for a local church in which all fees are waived The IPS prohibits holdings of companies involved in firearms, alcohol or tobacco These securities represent 5% of the benchmark, but the portfolio manager feels he can nonetheless implement his strategy with these restrictions The equity carve-out portfolio of a balanced account The client provides Arcadia discretion in the tactical asset allocation decision Asset allocation amongst sub-portfolios is performed quarterly and each sub-portfolio holds tactical or frictional cash A large cap equity mutual fund managed for a corporate retirement plan Employees can make contributions and withdrawals daily The client requires the portfolio manager to maintain at least 15% of assets in cash balances to meet potential withdrawals Finally, Westley examines a recent presentation to a prospective client regarding Arcadia’s small cap composite Details of this presentation are found in Exhibit and its notes Year Gross of Fees Return (%) 2005 2006 2007 2008 1Q09 Notes: 4.2 3.7 -1.0 9.3 5.2 Exhibit Small Capitalization Equity Composite Benchmark: Russell 2000 Net of Benchmar Number Internal Fees k Return of Dispersion Return (%) Portfolios (%) (%) 3.2 3.7 3.3 2.7 7.0 4.6 -2.0 -4.5 1.7 8.3 12.0 12 2.8 4.2 -7.0 14 3.6 Total Assets ($m) Composite Firm 100 225 350 425 620 By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose 1,000 1,250 900 1,050 1,125 Arcadia is an investment firm affiliated with a major global bank and founded in April 2001 The firm manages portfolios in various equity, fixed income and real estate strategies Arcadia has a number of affiliates owned by the parent company; a schedule is provided separately The composite has an inception date of 12/31/2003 A complete list and description of firm composites is available upon request The composite includes all fee-paying discretionary, nontaxable portfolios that follow a small cap strategy The composite does not include any non-fee paying portfolios 1Q09 data is not annualized Valuations are computed and performance reported in US$ Internal dispersion is calculated using the equal weighted standard deviation of all portfolios that were included in the composite for the entire year Gross-of-fees performance returns are presented before management and custodial fees but after all trading expenses The management fee schedule is as follows: 1.00% on first US$25M; 0.60% thereafter Net-of-fees performance returns are calculated by deducting the management fee of 0.25% from the quarterly gross composite return 55 In her statement to the CEO, Westley is most likely not correct with respect to: A verification B exclusion of the Phoenix division C the status of Swiss Corp’s other subsidiaries Answer: A ―Global Investment Performance Standards,‖ Phillip Lawton and W Bruce Remmington 2010 Modular Level III, Vol 6, pp 274-276 Study Session 18-48-c Explain the fundamentals of compliance with the GIPS standards, including the definition of the firm, the conditions under which an investment management firm can claim compliance, and the correct wording of the GIPS compliance statement A is correct because although GIPS standards recommend that firms undertake verification, it is not required to claim compliance The Phoenix office holds itself separate geographically, as well as with respect to personnel and its investment process Philadelphia will be able to be GIPS compliant even if its Phoenix office is not Finally, since Arcadia markets itself as separate and distinct from the other affiliates, it can claim compliance even if the others units are not compliant By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose 56 Which policy regarding input data is most likely incorrect? A Policy B Policy C Policy Answer: B ―Global Investment Performance Standards,‖ Phillip Lawton and W Bruce Remmington 2010 Modular Level III, Vol 6, pp 277-280 Study Session 18-48-d Explain the requirements and recommendations of the GIPS standards with respect to input data, including accounting policies related to asset valuation and performance measurement B is correct because GIPS requires all transactions to be recognized on the trade date and not the settlement date Trade date is when the transaction takes place, whereas settlement date is when the exchange of cash, securities, and paperwork involved in a transaction is completed 57 Which policy regarding return calculation methodologies most likely requires revision? A Policy B Policy C Policy Answer: C ―Global Investment Performance Standards,‖ Phillip Lawton and W Bruce Remmington 2010 Modular Level III, Vol 6, pp 280-289 Study Session 18-48-e Summarize and justify the requirements of the GIPS standards with respect to return calculation methodologies, including the treatment of large external cash flows, cash and cash equivalents, and fees and expenses C is correct because GIPS requires cash and cash equivalents to be included in total return calculations for all asset classes By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose 58 Inclusion of which portfolio reviewed by Westley in the large capitalization equity composite would most likely not be GIPS compliant? A Portfolio A B Portfolio B C Portfolio C Answer: C ―Global Investment Performance Standards,‖ Phillip Lawton and W Bruce Remmington 2010 Modular Level III, Vol 6, pp 293-305 Study Session 18-48-g,h,j Explain the meaning of ―discretionary‖ in the context of composite construction and, given a description of the relevant facts, determine whether a portfolio is likely to be considered discretionary Explain the role of investment mandates, objectives, or strategies in the construction of composites Explain the requirements of the GIPS standards for asset class segments carved out of multi-class portfolios C is correct because Portfolio C is required to hold too much cash at 15% for the portfolio manager to execute his strategy effectively The unanticipated nature of the contributions and withdrawals that can occur daily makes it difficult to invest the funds in equities This large cash balance implies the portfolio is nondiscretionary 59 Based on Exhibit and the notes following the exhibit, Arcadia is most likely not in compliance with GIPs with regard to the: A performance record B performance presentation C measure of internal dispersion Answer: A ―Global Investment Performance Standards,‖ Phillip Lawton and W Bruce Remmington 2010 Modular Level III, Vol 6, pp 308, 313-314 Study Session 18-48-l, s Explain the requirements and recommendations of the GIPS standards with respect to presentation and reporting, including the required timeframe of By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose compliant performance records, annual returns, composite market values, and benchmarks Identify errors and omissions in given performance presentations, including real estate and private equity performance presentations A is correct because Arcadia is required by GIPS to present 5-years of performance since the composite has been in existence for that period The small cap composite was started on 12/31/03 and therefore performance for 2004 should be presented After presenting years of performance, the firm must present additional annual performance up to 10 years 60 Regarding the notes to Exhibit 1, GIPS would most likely imply that: A Notes and are required and Note is recommended B Notes and are required and Note is recommended C Notes and are required and Note is recommended Answer: B ―Global Investment Performance Standards,‖ Phillip Lawton and W Bruce Remmington 2010 Modular Level III, Vol 6, pp 305-308 Study Session 18-48-k Explain the requirements and recommendations of the GIPS standards with respect to disclosures, including fees, the use of leverage and derivatives, conformity with local laws and regulations that conflict with the GIPS standards, and noncompliant performance records B is correct because Note is required as it describes the definition of the ―firm‖ used to determine the total firm assets Note is recommended as the firm is encouraged but not required to provide a list of the firms contained within the parent company Note is required as firms must disclose which dispersion measure is presented By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose ... accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation... accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation... accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates Candidates may view and print the exam for personal exam preparation